Imagine this scenario: Samantha is retired at 69, but a few years back she took out a reverse mortgage. Now, she’d like to be done with it, especially since the loan comes with a hefty interest rate of 6.75%.
She currently has about $375,000 in home equity while her reverse mortgage loan is close to $250,000. She also has about $300,000 in savings, but she’s wondering if she should use a chunk of those savings to pay off her reverse mortgage and live on her Social Security (about $2,500 a month) instead.
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Or, does it make more sense to stick with the status quo?
How does a reverse mortgage work?
A reverse mortgage allows homeowners who are at least 62 to borrow money based on the equity in their home. (Your equity is based on how much you’d get if you sold your home, minus how much you have left on your mortgage.)
Unlike a traditional mortgage, you don’t make monthly loan payments. Instead, the lender pays you, using your house as collateral.
“Reverse mortgage payments are considered loan proceeds and not income. The lender pays you, the borrower, loan proceeds (in a lump sum, a monthly advance, a line of credit, or a combination of all three) while you continue to live in your home,” according to the IRS.
Because it isn’t considered income, the money is tax-free and won’t generally impact your Social Security or Medicare benefits. But, you still have to pay property taxes and insurance.
Interest accrues on the loan balance, meaning the amount you owe goes up over time. If you have a high interest rate, that can add up — and fast.
It increases your debt while decreasing your equity, and the interest added to your balance each month can “use up much — or even all — of your equity,” explains the Federal Trade Commission about the risks of a reverse mortgage.
The total (including interest) must be repaid either when you move out and sell your home or after you pass away, in which case it must be repaid by your estate.
If you sell your home, you can use part of the proceeds of the sale to pay off the loan. This could make sense if you want to downsize or move in with family, or if you need to move into an assisted living facility.
However, if you continue living in your home until you pass away, your heirs will inherit the house — and the reverse mortgage.
The loan would have to be paid in full, if they decide to keep the home. If they instead decide to sell, “they must repay the full loan balance, or at least 95 percent of its appraised value if the loan balance owed is more than the home value,” according to the Consumer Financial Protection Agency.
Typically, they would have 30 days to repay the loan after receiving a notice from the lender (or turn over the home to the lender), although it’s possible to get an extension if they’re actively trying to purchase or sell the home.
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Options for paying off a reverse mortgage early
Maybe Samantha wants the peace of mind of owning her home, or maybe she wants to leave the house to her children without burdening them with debt. Whatever the reason, she does have a few options.
One of those options is to do nothing. She could choose to remain in her home, with enough money coming in from Social Security and her retirement savings to enjoy a comfortable retirement.
When she passes away, her children could sell it and use the proceeds to pay off the reverse mortgage. It’s a trade-off: Samantha lives more comfortably and leaves less to her children, or she lives a more spartan lifestyle to leave more to her children.
If Samantha does decide to pay the loan off early, she could consider refinancing (turning a reverse mortgage into a regular mortgage), though that may not make sense in a high interest rate environment.
She could also consider paying it all off in one lump sum, making a partial payment (such as paying off $50,000 to $100,000 now while preserving some of her savings) or making loan payments to reduce her interest over time. Or, she could keep the reverse mortgage and invest that money conservatively as part of her long-term retirement plan.
Even if Samantha can live off her Social Security and savings, she’ll still be responsible for paying property tax, insurance and maintenance on her home. Plus, she may not want to drain her savings in case she needs that money for an emergency or future medical care.
If you’re considering paying off a reverse mortgage early, it’s a good idea to sit down with a qualified financial advisor to model various scenarios based on your Social Security income, retirement savings, withdrawal rate and taxes — and how different scenarios would play out if you paid it off (either in a lump sum or with smaller payments over time).
This could help you make an educated decision based on calculations instead of emotion.
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This article provides information only and should not be construed as advice. It is provided without warranty of any kind.
